Lexmark: Is Printing Dead?

Investment Summary: Lexmark (NYSE:LXK) offers a compelling opportunity at its current levels. Lexmark has been written up in the past; however, the bear case seems so prominent on the street in the pricing of LXK (24.9% short interest as of Dec. 31, 2012), that given the fundamentals and misconception of the corporate printing/imaging business, there are multiple ways to win with the company (share repurchases, going private transaction, rebound in corporate spending, etc.).

With LXK's current price fluctuating between $23 and $27, LXK trades at roughly 2.30x ttm EBITDA and 13% to 15% FCF yield (defined as share price/FCF per share). Catalysts and resource conversion activities are already in place as management has already repurchased $440 million in shares and has paid out another $77 million in dividends since the second half of 2011.

The Current Strategy and Industry Description

Lexmark International Inc. (NYSE:LXK) provides businesses of all sizes with a broad range of printing and imaging products, software, solutions and services that help them to be more productive. Since separating from IBM in 1991, LXK's product line has expanded to include laser printers and multifunctional devices, as well as associated supplies, software, solutions and services. LXK reported $3.9 billion in revenue for the trailing 12-month period ending Sept. 30, 2012, with approximately 57 percent of that revenue coming from international sales.

LXK’s strategic vision centers around helping clients manage, capture and access content and processed as the world prints less and the consumer printer market is less profitable. The core initiatives include solutions & services growth and laser/multifunctional expansion. The company acquired Perceptive Software Inc., a leading provider of ECM software and document workflow solutions, in the second quarter of 2010 and acquired Pallas Athena, a leading provider of business process management, document output management and process mining and discovery software in the fourth quarter of 2011. The acquisitions build upon and strengthen LXK’s industry workflow solutions and managed print services capabilities and allow the company to compete in the faster-growing ECM, BPM and document-process automation software solutions markets. The acquisitions support LXK’s strategy of exiting the ink-jet and consumer printer market to focus on higher-margin software, managed print services and laser printers.

Historically, LXK has relied solely on the razor/blade model which led to intense price competition among manufacturers. The company, acknowledging the change, has now focused on switching to a more consultative approach focused on functionality and pages through managed print services/multifunctional printers and specialized industry solutions while still obtaining the lucrative, high-margin supplies revenue.

To understand LXK's strategy, it is important to understand the managed print services industry and its trends. According to Gartner, managed print services is described as "a service offered by an external provider to optimize or manage a company’s document output to certain objectives, such as driving down costs, improving efficiency and productivity, and keeping information secure. In an MPS, the service provider takes primary responsibility for meeting the customer’s office printing needs, including the printing equipment, the supplies, the service and overall management of the printer fleet.” In simple terms, LXK manages companies’ printing by choosing the most efficient printer setups and shipping more toner as needed.

Currently a little less than half of total expenditures within corporate printing (includes hardware, supplies and services) is spent on MPS spending versus the traditional purchasing model. According to Photizo, MPS is projected to overtake spending on the purchase of equipment by the end of 2013 and obtain over 60% of a $130 billion estimated market by 2015. While companies have been looking at various ways to cut capex, MPS has been a natural benefactor given a 30% decline in average costs once implemented. Given the benefits, industry analysts are projecting the market to grow at a 20% CAGR. Further, the Asia Pacific and Latin American markets are expected to grow by more than double the expected rates.

LXK, which was recognized as an industry leader within the MPS realm, has utilized MPS to build “sticky” relationships within corporate clients by offering print set ups that cut their customers' costs combined with various BPM and other document-focused software. Provided below is an excerpt of a client using LXK’s MPS services:

“Among its customers is American Signature Furniture, which operates more than 125 furniture stores under names such as Value City Furniture.”

“Lexmark helped us bring color printing to our stores,” said Chuck Cook, manager of technical services. “We print most of our signage … in the store now at quite a savings versus going to FedEx or Kinko’s to do that.”

LXK's ISS segment with primarily consists of the Company's printer and supplies portfolios. Given the Company's recent business inkjet exit and prior exiting of the consumer realm, LXK is primarily focused on mono and multifunctional laser printers. LXK distributes hardware and supplies through their internal sales teams and channel partners. The company has specialized teams primarily focused on financial services, retail, manufacturing, education, government and healthcare.

The primarily growth driver for the ISS segment beyond MPS has derived from the adoption of multifunctional laser printers “MFP.” While consumer pages and business inkjet have declined, MFP pages have steadily increased, growing 37% for 2008, 21% in 2009, 15% for 2010 and for 2011 recorded double digit gains in developing regions and high single digit gains within developed regions. Further, according to IDC, MFPs are projected to grow and gain market share within the EMEA and Latin America, at growth rates projected over 15% year over year, while inkjet is projected to decline roughly 16% year over year.

Perceptive Software - $143.9 Million in Revenues as of Sept. 30, 2012 TTM

Over the past few years, LXK’s management has focused on software companies as a growth driver and essential component when rolling out their MPS services. The strategy is essentially focused on ingraining LXK products further into its customers’ business operations. LXK’s first acquisition in the space was in 2010, when the company acquired Perceptive Software, which specializes in enterprises content management software.

Perceptive describes itself as providing “content in context.” Perceptive focuses on taking information in any number of ways and making it accessible in a company’s workflow. With the addition of Perceptive, LXK has been able to lever the platform for bolt-on acquisitions over the past two years. Each acquisition is described below.

Perceptive Software: LXK purchased Perceptive on May 2010. Perceptive’s two main products at the time were ImageNow and WebNow (cloud solution), a document management, imaging and workflow software that helps organizations capture and organize documents, and retrieve a precise page when needed. Perceptive’s main customers are concentrated within the business services, construction, government, financial services, healthcare, educational, insurance, manufacturing, media and publishing, mortgage lending, retail, public sector, shipping and distribution, and energy and water utilities industries.

Pallas Athena: LXK acquired Pallas Athena on Oct. 18, 2011. The company provides business process management, document output management, and process mining software to business organizations. It offers BPMone business process management software; and ModusOne, a document composition software to communicate with clients. The company also provides ReflectOne, a process mining software for internal audit applications that enables businesses to perform process discoveries and assessments. In a nutshell, Pallas Athena allows companies to become more efficient. For instance, companies today might manually draw flowcharts showing each point in the workflow. Pallas Athena’s process mining software examines the process electronically and automatically offers a pictorial view of how that process is working (according to an LXK employee).

Brainware: The Brainware software, which was purchased on March 2012 and is now called Perceptive Intelligent Capture, automates what used to be manual paper intensive tasks. Brainware is primarily used to scan invoices or A/P and automate the process. The product has been popular and adopted by many customers.

Nolij: Perceptive Software Inc. acquired Nolij Corporation for $31.9 million on March 2012. The company provides web based document imaging, data integration and forms processing solutions for public and private colleges and universities.

ISYS Search:ISYS, purchased on March 2012, automatically pulls and searches for information within different systems and presents them to the final user.

LXK’s software division has exhibited strong year-over-year revenue growth; however, the segment has not yet reached profitability given the company’s high costs driven by recent acquisitions. Once the acquisition spree is over, which was hinted in the last management call, LXK believes it can achieve typical software company operating margins out of the business. Overall, the ECM/BPM industry is currently estimated at $8 billion per year and is expected to grow 12% year over year.

Competition

Given LXK's shift on focusing on multifunctional printers/managed printing services and their document management software, LXK mainly competes with Xerox and to a lesser extent HP. To get a feel of the current environment, it is best to hear it from Xerox (NYSE:XRX), where in its first quarter 2012 analyst call Ursula Brown noted:

“I would speak about two companies outside of the other group. So the other group is Canon, Ricoh, KM [Konica Minolta], the normal technology people, technology hardware providers, and they are still infants in document outsourcing. They're really not large players. They are trying to get together solutions and offer them, but we really don't compete actively against them. The places that we -- the competitors that we compete actively against are HP, Lexmark and us. Those are the three people who are in this document outsourcing business, today, as mature players. I'll break out HP, of those three, as behind both Lexmark and Xerox."

"Yes, we have strength in the tech sector, in the telecom sector and in banking. I think Lexmark kind of does legal fairly well, and they do some financial fairly well. So we have to -- they're going to try to catch us in the places that we're good, and we're going to definitely try to catch them in the places that they are good. So I think the market is still very wide open, which is the good thing."

Bear Case: Is Printing Done?

The sentiment towards "old tech" is predominantly negative, pointing towards the recent changes in technology such as the tablet/smart phone boom as nail in the coffin for PCs and printers. Without a doubt technology is continually changing; however, the hype around printing dying seems akin to the last tech bubble, where any .com company would replace the physical location. Printing as a whole is a different animal and within the corporate realm, is not dying... or at least not at the rate everyone seems to believe.

My experience from working at various financial institutions and talking to others in different industries seems to support this idea. Currently, it appears that the ability to change from printed documents to viewing them on a tablet is not as feasible and will potentially take years before an alternative is attractive. In the meanwhile, LXK has continued to focus only on the corporate realm (important to note: focused on certain verticals/niches), while exiting the consumer side of the business which is declining at a faster pace combined with intense price competition.

The Good:

· Cheap absolute valuation and strong cash flow, primarily from the annuity like supplies business

· Strong balance sheet and creditworthiness, giving them staying power

· Capital allocation- buybacks and dividends. Since 2002, share count has decreased from 126.2 million shares to roughly 64.6 million

· Focused strategy gaining momentum: MPS & Perceptive gains

· Optionality in the software business

· Historically a solid ROIC business

· Exiting of the highly competitive inkjet business (estimated to save $85 million annually)

Free Cash Flow Analysis

2008

2009

2010

2011

2012 TTM

Revenue

$4,528

$3,880

$4,200

$4,173

$3,890

Adj. EBITDA

$510

$444

$646

$666

$561

Adj. EBITDA Margins

11.26%

11.44%

15.38%

15.96%

14.42%

Operating Income

$306

$216

$448

$443

$255

Net Income

$240

$146

$340

$321

$169

Cash Flow From Operations

$482

$402

$520

$391

$439

Less: CapEx

$218

$242

$161

$157

$171

Free Cash Flow

$264

$160

$359

$234

$268

Free Cash Flow Per Share

$2.97

$2.03

$4.49

$3.00

$3.49

Per the above chart, LXK has demonstrated the ability to consistently generate free cash flow over an economic cycle. This is further supported as the company managed to stay free cash flow positive in 2009, in which free cash troughed at $160 million. The increase in free cash flow from fiscal year-end 2009 to fiscal year end 2010, demonstrates the ability LXK has to shift gears and take advantage of certain conditions.

Under a simple SOTP valuation, we can take adjusted TTM ISS operating income (defined as ISS EBIT less corporate expenses plus certain restructuring charges) and we assume LXK could separate their software division at 1x revenues (seems conservative given growth exhibited and among prices paid) along with net cash and we get a fair idea what the company is potentially worth.

Sum of The Parts Valuation

3x

5x

7x

ISS Adjusted Operating Income

$1,378.8

$2,298.0

$3,217.2

Plus: 1x Perceptive Software Revenue

$143.9

$143.9

$143.9

Plus: Net Cash

$200.0

$200.0

$200.0

Est. Value

$26.67

$40.90

$55.13

Under a downside scenario of 3x operating income, the equity value is pegged at $26.67 per share. This downside case is slightly below this week's share price; however it has rapidly fluctuated given a recent sell off in 2012 due to sell-side downgrades. Further, if we believe LXK's profitable printing division is worth at least 5x operating income, our estimated value increases to $38 for our base case. As demonstrated below in our LBO analysis, we feel 5x operating income is conservative given a financial/strategic buyer could potentially pay more in a change of control scenario.

Resource Conversion: Given Management's commitment to return at least 50% of free cash flow per year to shareholders in the form of dividends and buybacks, LXK is slowly going private. LXK would benefit from a going private transaction as it will allow management to focus on the business instead of meeting the Street's relatively short-term focused goals. Furthermore, given that capital raised for PEGs is at an all time high along with many banks being asset starved, LXK would be an attractive candidate for a buyout given its leverage profile and cash flows.

Resource Conversion Scenario

2013E

2014E

2015E

2016E

Revenue

$3,591.0

$3,662.8

$3,736.1

$3,810.8

EBITDA-15% Margin

$538.7

$549.4

$560.4

$571.6

Interest Expense (9% blend)

$174.4

$172.6

$170.9

$169.1

Taxes

$53.9

$54.9

$56.0

$57.2

Pension- $230MM/10 years

$23.0

$23.0

$23.0

$23.0

CapEx

$150.0

$150.0

$150.0

$150.0

Principal Payments (1%)

$19.4

$19.4

$19.4

$19.4

Total Outflows

$420.6

$420.0

$419.3

$418.7

Free Cash Flow to Sponsor

$118.0

$129.5

$141.1

$152.9

Sponsor IRR @ 2016 Exit

Exit Multiple

4.50x

5.00x

6.00x

7.00x

IRR

19%

25%

33%

40%

The LBO scenario above assumes the following:

1) Company is taken private at $40 per share or roughly $2.5B, representing a 4.60x EBITDA multiple.

2) Company is financed with 25% equity or $645MM outlay and the rest in debt capital (mix of TLB & HYD).

4) EBITDA margins stay consistent at 15%, which is in line with the historic norm.

Not only would LXK be attractive for a financial buyer, strategic buyers could easily find value in LXK's product portfolio. We have seen in the past five years consolidation within hardware companies given the synergies and economies of scale that could be achieved. I wouldn't be surprised if we see an acquirer from Japan/Asia given the cash they are dropping presently in the market. Finally, an activist or control investor could unlock value given that the company is clearly cheap on an absolute basis and has the potential to add significant debt capacity (which could be used for buybacks or other purposes).

Projection Scenario

$ in Millions

Share Repurchase Scenario

2012E

2013E

2014E

2015E

Revenue

$3,780

$3,591

$3,411

$3,241

Adj. EBITDA

$544

$517

$491

$467

Adj. EBITDA Margins

14.40%

14.40%

14.40%

14.40%

Operating Income

$378

$359

$341

$324

Operating Income Margins

10%

10%

10%

10%

Free Cash Flow

$250

$233

$222

$211

Free Cash used for Dividends

$81

$84

$84

$84

Free Cash Used for Buybacks

$205

$100

$100

$100

Free Cash Flow Per Share

$3.87

$3.86

$3.92

$3.98

The share repurchase model above assumes the following:

1) Revenues decline 5% year over year due to a potential decline in LXK's core business segments, not giving any consideration for Perspective Software coming online

2) Share repurchases completed evenly throughout the year at $24, $26 and $27 per share

3) Operating income margins below management's goal or the norm at 10% and free cash margins at 6.5%

Under the buyback scenario, which I feel is a conservative projection in terms of declining revenues, free cash flow per share stays relatively consistent as the buybacks continue to fuel the company's dividends and share repurchase program. At current prices you are easily attaining a built in return greater than 8% through the combination of buybacks and dividends. However, it is basically a guessing game if management continues to repurchase shares and pay out dividends among other variables. I do have some confidence in the buybacks continuing.

Risks:

If Lexmark loses investment-grade status, what will the repercussions be for their upcoming $350 million debt refinancing?

Although a downgrade would potentially harm LXK's ability to tap the credit markets, given the company's excess cash position and cash flow generation (see fixed charge coverage above), LXK would be able to handle its obligations.

LXK's software acquisitions could destroy value and squander cash.

It appears that the company's investments have potential once the software business reaches a normalized state. Given the revenue growth exhibited, if the division reaches management's goals with software industry operating margins, Perceptive would be materially accretive to operating income. Mismanagement of the balance sheet

Management has maintained a net cash position; however, this has dwindled given LXK's build out of their software segment.

Roughly $800 million in cash is overseas, which they might possibly need to tap to pay off the 2013 notes and buyback shares.

This risk is mitigated as LXK can repay obligations through its untapped A/R securitization facility, if cash is unavailable.

Management stops returning capital as it is the best time ever for them to buy back shares.

Management has maintained its goal in returning 50% of free cash flow to shareholders in the form of share repurchases and dividends. A take under: It looks like LXK could be a very decent buyout target, especially at these prices.

If LXK enters a bidding process, given the recent environment, the company would potentially receive interest from multiple bidders. This could potentially lead to higher bids.Change in control provisions which were added in the third quarter is a wild card.

Even though insider ownership is lower than I like, management's actions so far have shown that they are focused on the business and are appropriately compensated if the company reaches certain free cash flow hurdles.

Conclusion

Given the depressed valuation that plagues LXK (and old tech in the whole), the concerns are mostly exaggerated, leading to extreme mispricing and volatility within the sector. LXK's management has proven that it is not asleep at the wheel and have strategically exited unattractive segments, while investing in growth (multifunctional laser printers, MPS and document management software) and prudently returning free cash flow to shareholders. We do admit that it is highly challenging in determining the pace of change within the tech world; henceforth at its current price it would be prudent to initiate a small position or add LXK to a basket of cheap old-tech stocks (Dell, Intel, Microsoft, Xerox, etc.).

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